What are called market-linked debentures are also known as structured debentures in the market. It is a debt instrument that has a unique association with both bonds and equity which makes it different from other instruments such as bonds and equity funds.
What are market-linked debentures?
A fixed-income instrument with returns that are associated with the market-linked underlying index such as Nifty 50 or Government Securities performance.
So with that said, the returns in the market-linked debentures are a little tricky. The returns are not fixed like that of a bond, in fact, both the principal and returns are received at the time of maturity.
The tricky thing is how an investor even receives the return. So here’s what you must know. When the issuers receive money from the investors through the debentures for an interest rate, it also has another criterion to meet that is the returns are only given if the underlying index to which the debenture is linked performs X percent from the time it was brought to the time it matures.
And if it falls below the X percent it was fixated upon, then the returns become zero.
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What about the Principal?
To understand if the principal is returned or not, let’s get into the types of market-linked debentures.
There are 2 types of Market Linked Debentures:
1. Principal protected
As the name suggests the principal is protected in this type of debenture. In response to the movements of the underlying index be it positive or negative, the principal surely is returned. Although the principal is subject to credit risk.
2. Non-principal protected
Now as exactly to its name, these are debentures that do not have principal preservation during the downside of the market. But on the upside of it, the returns are of course higher. In short, you’ll receive the principal if the market is doing as agreed upon and plus the returns. Otherwise, you will lose both capital and returns.
So based on which MLDs you pick, decides whether your capital is safe or at bay. In India, only principal-protected MLDs are issued. So that saves your capital but is subject to credit risk.
But how exactly do Market Linked Debentures work?
Since the MLD returns are linked to the performance of the market at large, it is technically a risky proposition. Let’s say you invest ₹ 10,00,000 in a Principal-Protected MLD which is linked to the Nifty 50 index. If the MLD has a term period of 3 years and a participation rate of 50%, this means that the MLD will pay a return on the appreciated value of the index at the end of the 3-year term. If the index has risen by more than 50% from the initial fixing date, you receive your flat 8% return just like that, without a fuss. But if the Nifty rose less than 50%, your returns would be calculated as Nifty rise * 1.1. If in case Nifty falls from the initial value, you get your principal back. The fixing values for both the initial and final fixing are set by taking the three-month averages. So on your ₹10,00,000, you may make ₹80,000 provided Nifty rose more than 50% and if Nifty 3 monthly final fixing value is less than the initial, you get your principal back.
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MLD: Features and Benefits
Market-linked debentures have many exciting features that make them seem attractive as an investment option for many investors but it is advised to tread with care as some of the nuances can be hard to understand and may require close examination.
Features of MLDs
1. Face Value
This is just the principal amount that the investor will receive at maturity. The face value is usually fixed, but the returns are linked to the performance of the index or the asset that the MLD is tied to.
2. Underlying Index
MLDs offer investors exposure to a range of indices. It is necessary for the investor to be aware of what is the specific type of index for a particular MLD. It can either be Nifty 50 or government security.
3. Interest Payment at Maturity
Market-linked debentures usually do not pay interest during the investment tenure. Instead, the investor receives the returns linked to the performance of the index that the MLD is exposed to at the time of maturity.
Benefits of Market-Linked Debentures
1. Hybrid Exposure to Asset Classes
As MLDs are exposed to a multitude of carefully analyzed finance modes, MLD investments can be considered relatively safe provided the investor feels confident about the asset classes that the MLD is exposed. These investments can be used as a risk control mechanism.
2. Safeguarded against negative risks
Principal-protected MLDs ensure that investors receive the principal amount at maturity, even if the underlying asset or index performs poorly. This feature provides a measure of protection against downside risk.
3. Superior return potential
MLDs offer the potential for superior returns compared to traditional fixed-income investments while also managing risk, unlike stocks.
Risks Associated with Market-Linked Debentures
Market Linked Debenture investments promise the return of principle and a hefty return in such a short span of time. Before you say shut up and take my money, it is noteworthy to consider the risks associated with the microscope. Here are a few risks that come with MLD investments.
1. Credit risk
MLDs are also subject to credit risk, which is the risk of default by the issuer. If the issuer defaults on the payment of interest or principal, the investor may lose a portion or the entire investment amount.
MLDs may have a credit rating, ranging from AAA followed by AA+, AA, AA- to BBB, with lower-rated MLDs indicating the borrower’s lower creditworthiness.
Additionally, MLDs are not covered by the Deposit Insurance and Credit Guarantee Corporation (DICGC), which means that in case of default by the issuer, the investor may lose the entire investment amount
2. Market risk
The main risk associated with MLDs is market risk, where the performance of the underlying asset is subject to market fluctuations. If the market experiences a downturn, the value of the MLD may decrease, leading to losses for the investor if it isn’t a principal-protected MLD.
3. Liquidity risk
MLDs may have low liquidity, making them difficult to sell before maturity.
Understanding the underlying index
The underlying index can vary and includes Nifty, bank nifty, government securities, and gold which is why it is crucial to be aware of the type of exposure you have by investing in an MLD. These investments offer the benefit of exposure and upside in other markets, such as equity or G-sec, without taking as much of a risk as investing directly into that asset. They are considered attractive investments that protect against downside risks while ensuring attractive gains, particularly in a low-interest rate environment. Moreover, the benefits from tapping into different markets without direct investments and tax efficiency make them worthy of a place in the portfolio, especially for HNIs
Duration and liquidity of Market-Linked Debentures
Duration: MLDs do not have a fixed maturity date like traditional bonds, and their tenor can vary depending on the issuer’s discretion. For example, Edelweiss Financial Services issued MLDs with tenors of 3, 4, and 5 years. The tenor of MLDs may also depend on the underlying index or security, such as Nifty 50 or 10-year G-sec. So, the duration of MLDs can vary based on the issuer’s discretion and the underlying asset’s performance.
Liquidity: Listed MLDs are traded on the stock exchange and may provide intermittent liquidity. But the liquidity of MLDs also depends on the prevailing market conditions and the demand from buyers and sellers. It is important to note that non-listed MLDs may offer limited liquidity compared to the listed ones with good credit ratings.
Taxation of Market-Linked Debentures
The taxation of income from Market-Linked Debentures (MLDs) saw some changes in the 2023 budget. Previously, all revenue from MLDs was taxed at a fixed rate of 10%. However, from April 1, 2023, a new rule applies taxes on any income from MLDs at the investor’s slab rate. This means that the tax rate will vary based on an individual’s income bracket, with the highest tax bracket in India having a potential tax rate of up to 30%.
When an investor sells MLDs, any profits they make are treated as capital gains, and the tax rate depends on the length of time the investor held the investment. Short-term capital gains, which are profits made from selling an MLD within a year of purchase, are taxed at the investor’s slab rate. On the other hand, long-term capital gains, which are profits from selling an MLD after holding it for more than a year, are taxed at a fixed rate of 20% after accounting for inflation.
It is worth noting that the long-term capital gains arising from MLDs are currently taxed at 10%, without any indexation benefit. However, the representative body of India’s non-banking finance companies (NBFCs) has requested the government to provide long-term tax benefits for debt products, including MLDs.
Inferences
Firstly, it is important to note that while MLDs can offer higher returns compared to traditional fixed-income investments, they come with higher risks. Investors should carefully consider their risk appetite and investment objectives before investing in MLDs.
Secondly, the Association of Non-Banking Finance Companies in India has requested the government to provide tax benefits to debt products, including MLDs, to encourage their use by investors.
Thirdly, some investment firms, such as Goldman Sachs, are bullish on India’s private markets and see opportunities for investors to benefit from this segment of the market.
Fourthly, there have been recent changes in India’s Union Budget of 2023 that aim to curb mis-selling of investment products, which should benefit investors by increasing transparency and reducing the risk of costly mistakes.
Lastly, while there have been recent improvements in India’s financial markets, there remains a need for better liquidity for retail investors in government securities markets.
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FAQs
1. What are marked linked debentures?
A fixed-income instrument with returns that are associated with the market-linked underlying index such as Nifty 50 or Government Securities performance.
2. What are the types of MLDs?
There are two types in it: Principal protected MLD and Non principal-protected MLD. In India, only Principal protected MLDs are issued.
3. As per the union budget, how are debentures taxed?
Previously, all revenue from MLDs was taxed at a fixed rate of 10%. However, from April 1, 2023, a new rule applies taxes on any income from MLDs at the investor’s slab rate.
4. What underlying indices are associated with the MLDs?
The underlying index can vary and includes Nifty, bank nifty, government securities, and gold.
